ADBI Working Paper Series
Revisiting the Internationalization
of the Yuan
Yongding Yu
No. 366
July 2012
Asian Development Bank Institute
Yongding Yu is an academician at the Chinese Academy of Social Sciences (CASS) and
a senior fellow at the Institute of World Economics and Politics of CASS.
An earlier version of this paper was presented at the ADBI Annual Conference on
Reform of the International Monetary System held in Tokyo on 2 December 2011.
The views expressed in this paper are the views of the author and do not necessarily
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Suggested citation:
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Asian Development Bank Institute. Available: http://www.adbi.org/workingpaper/2012/07/04/5137.revisiting.internationalization.yuan/
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© 2012 Asian Development Bank Institute
ADBI Working Paper 366
Yu
Abstract
As the world’s second largest economy, largest trading nation, and the largest foreign holder of
United States (US) government bonds, the People’s Republic of China (PRC) needs a currency
with international status that can match its economic status in the global economy. However,
sequencing is important. Before the internationalization of the yuan can make meaningful
progress, necessary conditions, such as the existence of deep and liquid financial markets, a
flexible exchange rate and interest rates responsive to market conditions must be created.
The process of yuan internationalization essentially is a process of capital account liberalization.
Due to the unprecedented and complex global financial crisis and the PRC’s huge imbalances,
capital account liberalization has to be pursued in a cautious way. As a result, the
internationalization of the yuan is bound to be a long-drawn process.
The PRC’s road map for the internationalization of the yuan is flawed with many missing links
and wishful thinking. Yuan internationalization guided by the current road map may be proven
counterproductive.
JEL Classification: F31, F33
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Contents
1.
Introduction ..................................................................................................................... 3
2.
Functions of an International Currency ........................................................................... 3
3.
Possible Benefits of Yuan Internationalization for the PRC ............................................. 6
4.
The Road Map of Yuan Internationalization .................................................................... 7
5.
Progress in Yuan Internationalization.............................................................................11
5.1
5.2
5.3
5.4
6.
Use of the Yuan for Trade Settlement ................................................................12
Yuan Deposits held by Hong Kong, China .........................................................13
The Issuance of Yuan Denominated Bonds .......................................................14
Yuan Swaps with Foreign Central Banks ...........................................................14
Problems of Yuan Internationalization............................................................................15
6.1
6.2
Asymmetry of Yuan Internationalization and Resulting Welfare Losses to the
PRC ...................................................................................................................15
Surge in Speculative Short-term Capital Flows ..................................................18
7.
Yuan Internationalization and Capital Account Liberalization .........................................20
8.
Conclusion .....................................................................................................................23
References ...............................................................................................................................25
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1. INTRODUCTION
Since its launch in early 2009, the internationalization of the yuan has been making rapid
progress. As the world’s second largest economy, largest trading nation, and the largest
foreign holder of United States (US) government bonds, the People’s Republic of China (PRC)
needs a currency with international status that can match its economic status in the global
economy. While the PRC economists universally support the internationalization of the yuan as
a long-term goal, worries about the possible negative impact of the PRC monetary authorities’
current push for the internationalization on the PRC’s welfare and financial stability have
emerged since 2010. In fact, yuan internationalization has become one of the most
controversial issues among economists in the PRC.
This chapter is a reexamination of the endeavor of yuan internationalization since 2009. The
main findings are that despite the progress made, the PRC does not have a viable road map
for yuan internationalization yet, and perhaps it cannot have one. The much-proclaimed project
could prove an anticlimax. In the short term, the PRC’s policy focus should not be on
promoting the internationalization of the yuan, because there are many more urgent
challenges to face. The reform of the PRC’s exchange rate regime and liberalization of interest
rates should take precedence. Needless to say, to carry out capital account liberalization
disguised as yuan internationalization without having met necessary prerequisites is
dangerous.
Section 2 is a brief survey of the literature on the definition and characteristics of an
international currency. Section 3 deals with the objectives of the PRC’s efforts in promoting
yuan internationalization. Section 4 gives critical assessments on the PRC’s road map of yuan
internationalization. The fifth section examines the progress the PRC has made and section 6
discusses some of the problems arising from yuan internationalization. Section 7 discusses the
relationship between yuan internationalization and capital account liberalization. The final
section offers concluding remarks.
2. FUNCTIONS OF AN INTERNATIONAL CURRENCY
There is a large body of literature on the nature of an international currency and the ways to
internationalize a national currency. According to Kenen (2009), an international currency is
used and held beyond the borders of the issuing country. An international currency is not
merely used for transactions with residents but is also used for transactions between residents
and nonresidents. Theoretical discussions of currency internationalization usually begin with
the functions of an international currency. Kenen (1983) presents some early thoughts on the
roles of international currencies. Chinn and Frankel (2005) provide a list of international
functions of an international currency (Table 1).
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Table 1: The Role of an International Currency
Function of money
Governments
Store of value
International reserves
Medium of exchange
Foreign exchange market
intervention
Unit of account
Anchor for pegging local
currency
Private actors
Currency substitution (private
dollarization) and investment (portfolio
allocation)
Vehicle currency, invoicing trade and
financial transactions, settlement
currency
Denominating trade and financial
transactions
Source: Based on Chinn and Frankel (2005).
According to Chinn and Frankel (2005), an international currency should be a store of value, a
medium of exchange, and a unit of account for both residents and nonresidents. The functions
can be further divided into two subfunctions: private use and public use. When an international
currency is used for private purposes, it is used for currency substitution, bridging currency
trading in foreign exchange markets, and invoicing and denominating trade and financial
transactions. When it is used for public purposes, it is used as a reserve currency, an
intervention currency, and an anchor currency.
The above-mentioned functions of an international currency will be used as a point of
reference as this study assesses the progress of yuan internationalization and explores
possible routes for internationalization. A currency can play the role of an international
currency on different levels. For example, among all the functions of an international currency,
the most supreme is the role of an international reserve currency. It seems that on the second
highest level stands the role of vehicle currency.
Understanding differs on the classification of the functions of an international reserve currency.
For example, according to Ito (2011), the role of an international currency can be classified as
follows (Table 2).
Table 2: Dimensions of an International Currency
Unit of account
Medium of
exchange
(settlement)
Store of value
Private sector
Trade invoicing
Denomination of financial
products
Trade and financial transactions
Cross-border deposits
Cross-border securities
Official sector
Being pegged by other countries
Use in currency baskets of foreign
central banks
SDR composition currency
Denomination of government
bonds
Currency circulation abroad
Government financial transactions
(such as ODA) Central bank swaps
Currency intervention
Foreign reserves (of other
countries)
Notes: ODA = official developmment assistance; SDR = Special Drawing Rights.
Source: Ito (2011) based on the matrix first proposed by Kenen.
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It is worth noting that in table 2, “trade invoicing” is put under the category of “unit of account”
rather than “medium of exchange”. It seems that both roles of invoicing trade and
denominating financial transactions should fall in the category of unit of account. Another
important point is that a distinction between the role of invoicing and that of settlement must be
made clear. It is very common that while a currency is used as an invoicing currency in a
certain transaction, settlement is made in another currency for the same transaction. As
pointed out by Ito, Satoshi, Sato, and Shmizu (2010), Special Drawing Rights (SDR) is a unit of
account but not a settlement currency. The recognition of the difference between these two
roles is very important.
As an international currency, the role of the invoicing currency is more fundamental than that of
the settlement currency. If exporters’ most important consideration is to avoid exchange rate
risks, they would prefer to use their own national currency to invoicing trade. As long as
exporters can convert the settlement currency into their own national currency, it does not
matter that much what currency is used for trade settlement. In contrast, if trade is invoiced in
a foreign currency, then the use of the national currency as the settlement currency will not
help exporters to avoid an exchange rate risk. The same is true of importers, though they are
exposed to opposite exchange rate risks.
If the invoicing currency has been decided, the choice of settlement currency is not entirely
irrelevant. Settlement currency as a medium of exchange performs different roles from those of
an invoicing currency. Because possible time lags between the settlement of trade and
currency exchange and possible changes in the exchange rate during this time, the choice of
settlement still makes a difference in terms of profits and losses for exporters and importers.
When an invoicing currency is decided, the direction of change in the exchange rate should be
a very important consideration. In contrast, when a settlement currency is chosen, the stability
of a currency should be a priority.
Generally, when exporters are in favor of one currency as the invoicing currency, they would
be in favor of the same currency as the settlement currency. This is also true of importers. But
in reality, the situation can be more complicated. In many discussions an implicit assumption is
made that a settlement currency must be an invoicing currrency at the same time. This
assumption is misleading, because the causes leading to the use of a currency as the
invoicing currency or the settlement currency are not the same.
Park (2010) points out that a greater usage in financial denomination rather than trade
invoicing appears to be a much more important qualification for a major international currency.
Daily turnover of the world’s currency markets (all instruments included) was close to $4 trillion
a day in 2010, while the value of world merchandise exports fell 23% to $12.15 trillion in 2009,
and world commercial services exports declined 13% to $3.31 trillion (WTO 2010).
When a currency is referred to as a store of value, it may refer to the currency in the form of
cash and deposits, or to the fact that financial assets and liabilities are widely denominated by
the currency. Holding a currency in the form of cash and deposits as store of value is different
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from holding financial assets denominated in the currency. The difference between the two
forms becomes obvious during a financial crisis. It should be emphasized that an international
currency need not be equally widely used in denominating both financial assets and liabilities
of the issuing country of the currency. For example, while US foreign liabilities are
overwhelmingly denominated in the dollar, its foreign assets are mostly denominated in foreign
currencies. The ultimate test for a currency’s international position is the extent to which the
currency can be used to denominate liabilities of the issuance country.
3. POSSIBLE BENEFITS OF YUAN INTERNATIONALIZATION
FOR THE PRC
Why did the PRC monetary authorities decided to push the internationalization of the yuan so
vigorously? What are the specific results the PRC government wishes to achieve by pushing
yuan internationalization?
First, the internationalization of the yuan will reduce exchange rate risks, to which the PRC
firms are exposed. The internationalization of the yuan means that more foreign trade and
financial transactions will be invoiced and settled (paid) in the yuan. As a result, the exchange
rate risks for the PRC firms will be reduced or canceled out accordingly. Because of the PRC’s
persistent current account and capital account surpluses, yuan appreciation pressure has been
building up steadily since early 2003. Many believe that if exports are invoiced and settled in
the yuan, the PRC exporters will be able to avoid exchange rate risk while the yuan is in the
process of appreciation, and hence the momentum of the PRC’s exports can be maintained. 1
Second, the internationalization of the yuan will reduce the PRC’s transaction costs in trade,
including the cost of trade finance, and lead to a further expansion of international trade. The
rapid increase in the use of the yuan as a settlement currency (payment currency) has greatly
boosted the PRC’s border trade.
Third, the internationalization of the yuan will improve the funding efficiency of the PRC’s
financial institutions, hence increasing their international competitiveness and lead to the
expansion of the PRC’s financial services sector. It is conducive to the PRC’s efforts for
developing Shanghai as an international financial center.
Fourth, the internationalization of the yuan means that the need for the PRC to hold the dollar
as a medium of exchange and a store of value will be reduced accordingly, which in turn
1
Unfortunately, the assumption is likely wrong. With the yuan as invoicing and settlement currency, the appreciation
of the yuan will lead to the loss of market shares by the PRC exporters and hence the reduction of exports
anyway.
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means that the PRC will be able to reduce seigniorage paid to the US. 2 Taking into
consideration the high probability that in the long run the dollar will devalue further and the US
government will inflate away its debt burden by monetizing its budget deficit (such is already
the perception of quantitative easing), by reducing the holding of dollar denominated financial
assets, the PRC will be able to reduce capital losses on its huge foreign exchange reserves in
the future.
4. THE ROAD MAP OF YUAN INTERNATIONALIZATION
Historically, for most countries, the internationalization of their currencies has been marketdriven and without any road maps. 3 In fact, many countries have resisted the pressure to
internationalize their currencies. In Japan, the internationalization of the yen was launched
under US pressure. The road map for yen internationalization was essentially a road map for
capital account liberalization in line with US wishes (Takagi 2009). It seems that there is no
precedent for successful internationalization of a currency that is guided by a predetermined
road map. Among those countries with a form of road map, Japan failed to promote yen
internationalization as planned. Germany succeeded in making the euro an international
currency, but it came at the expense of the Deutsche mark and it is abundantly clear in the
wake of the eurozone sovereign debt crisis that Germany was forced into a suboptimal
monetary union. Although in the literature some clues for categorizing the routes leading to the
internationalization of a national currency can be found, there is no extensive discussion on
guiding principles for drawing a viable road map for currency internationalization. 4
The PRC’s road map 5 for the internationalization of the yuan follows what could be called “a
functional approach.” For the designers of the road map, the final destination of
internationalization is to make the yuan on par with the dollar in playing the role of an
international reserve currency. To arrive at this destination, conditions have to be created to
enable the yuan, as much as possible, to fulfill the functions of an international currency. But
2
Seigniorage amounts to the return on the extra assets (real and financial) that a country is able to acquire because
of the external holdings of its currency, less the interest paid on the assets in which the foreigners invest their
holdings and less any extra administrative costs arising from the international role of its money (Pearce 1981:
389).
3
4
5
Eichengreen and Flandreau have argued differently (2010).
Park (2010) proposed that the PRC should follow a regional approach to the internationalization of the yuan.
The PRC authorities have not published any formal documents to present the road map of yuan
internationalization. However, based on available documents that are aimed at addressing operational problems
with regard to yuan internationalization and talks and papers by those who are close to the decision makers, we
still can have a glimpse at what is in the mind of authorities on how they are prepared to push yuan
internationalization.
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the journey of the yuan to the world is staged in order of difficulty. Yuan internationalization has
to start by making the yuan available to nonresidents. This appears logical. Without making the
yuan available to non-residents, how can the yuan be used internationally? The PRC has a
specific advantage in the form of the existence of Hong Kong, China—an international financial
center and the single most important entrepôt for the PRC. Hence, yuan internationalization
starts with the promotion of the use of the yuan for settling imports from Hong Kong, China.
The PRC monetary authorities proclaim that no artificial incentives have been provided to
encourage the PRC importers to use the yuan as a settlement currency. What it has done is to
remove the restrictions on the choice of currency for trade settlement by the PRC enterprises
in several steps. However, it has to be asked: although freedom of choice has been given to
the PRC importers, why must they choose the yuan instead of other currencies for import
settlement, especially when taking into consideration the fact that the yuan has been on the
course of appreciation for six years and is likely to continue in the foreseeable future? Of
course, Hong Kong, China exporters can be asked a similar question: why would they be
happy to accept yuan payments? Unfortunately, in the PRC’s road map, these questions are
not asked, let alone answered.
There are a large number of theoretical and empirical studies exploring the selection of an
invoicing currency (Grassman 1973; Goldberg and Tille 2008; Friberg and Wilander 2008;
Kawai 1996; Ito, Satoshi, Sato, and Shimizu 2010). According to these studies, trade between
industrialized countries in manufactured products tends to be invoiced in the exporter’s
currency. Trade between an industrialized and a developing country in manufactured products
tends to be invoiced in the industrialized country’s currency. Trade between any pair of
countries in primary products tends to be invoiced in an industrialized country’s currency
(Kawai 1996). Despite the fact that no conclusive results have been achieved, it is clear that
the determinants of the choice of the invoicing currency are multifold. Exchange rates and
expectations of exchange rate changes will influence an enterprise’s choice of invoicing
currency. Other factors on industrial and enterprise levels, such as a country’s industrial
structure, corporation organizations, enterprise business models and marketing strategies,
types of products available, and development of relevant financial markets, may fundamentally
influence an enterprise’s choice of invoicing currency. The bargaining powers of trade partners
also play an important role in deciding the final use of invoicing currency.
It is worth noting that in the literature, there are a lot of discussions on the choice of the
invoicing currency, but relatively few discussions on the choice of the settlement currency. 6
When people talk about the use of the yuan for trade settlement, no one has asked whether
the yuan is also used for trade invoicing. For foreign observers, it must be the case. But it is
not. When trade is settled in yuan, it is not necessarily invoiced in yuan. In the PRC’s road
map, promoting the use of the yuan as invoicing currency has rarely been explicitly discussed.
6
Perhaps this is because the chosen settlement currency usually is the same currency for invoicing.
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As long as the yuan is used for trade settlement and hence yuan have flown out of the country,
the designers of the road map do not seem to worry whether the yuan is used as the invoicing
currency. However, if imports are still invoiced in dollars, the use of the yuan for settlement is
not a great accomplishment in yuan internationalization. On the contrary, this situation can be
a result of some perverse activities such as betting on yuan appreciation and can be easily
reversed when circumstances change.
Why does the use of the yuan for import settlement occupy such a central place in the PRC’s
road map? There are two possibilities. One is to enable Hong Kong, China residents to hold
yuan assets. Another is to enable Hong Kong, China residents to use the yuan to pay for their
imports from the PRC. It seems that the PRC’s emphasis is on encouraging Hong Kong, China
residents to hold more yuan assets. To achieve this, the PRC government created
mechanisms for the recycling of the yuan, soon after the yuan settlement for trade was
launched. The essence of recycling is to create channels for Hong Kong, China residents to
invest their yuan proceeds received from the PRC importers (and yuan obtained via other
channels) in yuan assets provided by the PRC financial institutions. 7 Without the recycling,
Hong Kong, China residents would have no option but to deposit their yuan with Hong Kong,
China banks, which is not a great incentive for them to hold yuan assets due to low interest
rates. It is worth noting that the yuan deposits with Hong Kong, China banks end up with the
Shenzhen branch of the People’s Bank of China (PBOC), which in turn pays interest on
deposits. Generally, investment in yuan denominated assets such as yuan government bonds
and yuan corporate bonds, if available, would give investors in Hong Kong, China higher
returns. The issue here is not how the yuan can be recycled. The yuan has been recycled
when Hong Kong, China residents deposit their yuan proceeds with Hong Kong, China banks.
The real issue is, given possible costs, how much freedom the PRC government is willing to
give to Hong Kong, China residents to choose yuan denominated assets to invest their yuan
and how Hong Kong, China residents would utilize these opportunities, if they become
available. This is a matter of capital account liberalization rather than one of yuan
internationalization.
According to the road map for yuan internationalization, as a result of the accumulation of yuan
assets by nonresidents (mainly Hong Kong, China residents), “somehow” incentives will
increase for nonresidents to pay for the PRC exports with the yuan, which they obtained from
selling goods and services to the PRC. Unfortunately, the road map has mixed two different
functions of an international currency—the function of medium of exchange and that of store of
value. As a medium of exchange, the yuan should move back and forth across borders
constantly 8 rather than be withdrawn from circulation and accumulated in various forms of
yuan assets. If the objective is to make the yuan a store of value and the objective has been
7
8
Hong Kong, China institutions also created various types of yuan assets for investment.
Or the yuan stays in Hong Kong, China to facilitate trade and financial transactions in Hong Kong, China, if the
yuan is accepted to perform these functions.
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achieved, then there would be no yuan left for Hong Kong, China importers to settle their
imports from the PRC. For Hong Kong, China residents, the yuan cannot play both the role of
medium of exchange and that of store of value at the same time. There is no “somehow” as
hoped for in the PRC’s road map. The incentives for Hong Kong, China importers to use the
yuan for import settlement should be different from the incentives for them to hold yuan assets.
Hence, it is possible that, after a long journey, it is still difficult to encourage Hong Kong, China
importers to use the yuan for settlement. Many links between different legs of the yuan’s
journey in the road map simply do not exist.
As mentioned earlier, an internationalized currency must be widely used not only in invoicing
and settling international trade but also in denominating financial transactions. Although since
the launch of yuan internationalization, the PRC government has promoted the sale of yuan
denominated bonds (both public and corporate), there seems to be no plan for the promotion
of the use of the yuan as a denominating currency for financial assets. As pointed out by Park
(2010), while there is a large amount of literature on how a currency can be used
internationally for trade invoicing, very little has been written on the determinants of a currency
for the denomination of financial assets. Perhaps, the role of financial assets denomination is
difficult to separate from the role of value storage. Hence, the promotion of the use of the yuan
for the denomination of financial assets will not be high on the agenda, until headway has been
made for the use of the yuan as store of value. Furthermore, the extensiveness of the use of
the yuan as the denominating currency for financial assets depends on the role of the PRC
financial institutions in global finance. Unfortunately, although the PRC has some of the
biggest banks in the world in terms of market capitalization, the PRC financial institutions’
global presence is insignificant. For whatever the reason, the question of how the yuan will
play the role of denominating currency for international financial assets has not been explicitly
addressed in the PRC’s roadmap.
The promotion of the use of the yuan as store of value has taken a few different routes. First,
as mentioned earlier, yuan denominated assets are provided mainly for Hong Kong, China
residents in connection with the scheme of yuan recycling. Though the PRC has yet to put
forward a timetable, the sequencing of the provision of yuan assets has emerged. Different
types of yuan assets will be provided corresponding to their possible impact on the PRC’s
financial stability. So far, Hong Kong, China residents are allowed to hold yuan deposits, yuan
corporate bonds, and yuan government bonds. In the future, they may be able to invest in the
PRC “A share” markets. The restrictions on the amount of investment will be loosened
accordingly. The increase in the holdings of yuan assets by Hong Kong, China residents
means that the PRC is borrowing from nonresidents. But with huge surplus capital and $3.2
trillion in foreign exchange reserves, why should the PRC be so keen on attracting more
foreign capital, even if these assets are denominated in the yuan? The escape route should be
to encourage nonresidents to hold yuan liabilities, for example, panda bonds. Unfortunately,
this route is not fully explored.
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The PBOC has entered into swap arrangements with some foreign central banks. This can be
regarded as a second route. The holding of yuan deposits by foreign central banks with the
PBOC has the potential to become an important channel for promoting the use of the yuan as
reserve currency, due to the PRC’s strong external position and the liquidity shortage of the
global economy.
The third route can be the further participation in regional financial cooperation. Park (2010:19)
points out, “In the event that the PRC decides on a regional strategy, it has two options to
consider. The PRC might move to create a yuan bloc among the members of ASEAN + new 3,
which includes ASEAN10, the PRC, Taipei,China, and Hong Kong, China. Alternatively, it
could take advantage of ASEAN+3 as a framework for yuan internationalization.” The PRC’s
current road map is pointing to the direction of the first option in what Park labeled the
“regional approach”. The PRC’s promotion of yuan trade settlement with Hong Kong, China
can be regarded as the first leg in the long journey in line with the ASEAN + new 3 approach.
However, the PRC monetary authorities have not given up pushing yuan internationalization
via the second regional approach. 9 More precisely, the PRC authorities are still hoping more
can be done to consolidate the regional financial architecture within the framework of the
Chiang Mai Initiative. Something conducive to yuan internationalization may materialize as a
by-product of the PRC’s engagement in regional financial cooperation. Currency swaps
between central banks are cases in point.
Another important direction in the yuan’s journey to the world is the participation in the reform
of the international monetary system. But it seems that the PRC has not yet decided how to
participate in the reform. For example, there is not yet a policy on what role the yuan should
play in redefining the SDR.
In summary, it is expected by the PRC’s decision makers that with the increase in yuan import
settlement combined with policies aimed at facilitating yuan recycling, cross-border yuan flows
will increase gradually and so will the stock of yuan held by nonresidents. The continuation of
such cross-border flows somehow will eventually make the yuan an international currency that
will be able to perform a full scope of functions. Unfortunately, because there are too many
missing links in the road map, the yuan’s journey could be very bumpy and even may not end
up at the planned destination.
5. PROGRESS IN YUAN INTERNATIONALIZATION
The PRC seems to have made significant progress in the use of the yuan as a settlement
currency, in the issuance of yuan-denominated bonds, and in signing currency swaps
9
The PRC’s enthusiasm for yuan internationalization is partially a result of the disappointment for the lack progress
of regional financial cooperation.
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agreements with foreign central banks. The most hailed progress is the exponential growth of
yuan deposits in Hong Kong until September 2011.
5.1
Use of the Yuan for Trade Settlement
The PRC announced a pilot yuan trade settlement scheme (PRTSS) in April 2009, with an
extension of the scheme announced on 22 July 2010. Now virtually all important PRC firms are
allowed to use the yuan to settle trade. The types of trade eligible for yuan settlement have
also expanded to include not only physical goods but also services. As a result, the amount of
yuan trade settlement has increased dramatically since the third quarter of 2010. According to
the Hong Kong Monetary Authority (HKMA), the volume of yuan cross-border trade settlement
conducted through Hong Kong reached 1.9 trillion yuan in 2011 (Figure 1).
Figure 1: Increase in the Use of the Yuan for Trade Settlement
(billion yuan)
Source: Zhang (2012).
The share of yuan trade settlement in the PRC’s total foreign trade is another important
indicator for the progress in yuan internationalization. In 2010, yuan trade settlements
accounted for only 2.5% of the PRC’s total trade. In 2011, the corresponding figure rose
dramatically to 9% of the PRC’s total trade (PBOC 2011).
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Yuan Deposits held by Hong Kong, China
The most direct and immediate result of the increase in yuan settlement for imports is the
dramatic increase in yuan deposits held by Hong Kong, China residents. As of July 2011, the
total amount of yuan deposits was 580 billion yuan, equivalent to HK$899 billion and
accounted for 9.5% of the total HK$947 billion of deposits in Hong Kong, China—up from less
than 2% just a year ago. It was widely expected that the total amount of yuan deposits would
reach 1 trillion yuan by the end of 2011 (Figure 2). 10
However, the momentum in demand for yuan deposits in Hong Kong, China suddenly lost in
the third quarter of 2011 (Figure 2). As of the end of March of 2012, total yuan deposits held by
Hong Kong, China residents was just 554.3 billion yuan. The reason for this change will be
explained in section 6.
Figure 2: Yuan Deposits held by Hong Kong, China Residents
(billion yuan)
Source: Zhang (2012).
10
As of the end of September 2011, deposits in Hong Kong, China reached 622.2 billion yuan.
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The Issuance of Yuan Denominated Bonds
Yuan denominated bonds sold by non-PRC issuers in the PRC are called “panda bonds.” The
first two panda bonds were issued on the same day in October 2005 by the International
Finance Corporation and the Asian Development Bank. When foreign-funded enterprises in
the PRC are in need of yuan, they can issue panda bonds to borrow yuan to finance their
economic activities in the PRC. The yuan raised though such channels can only be used in the
PRC.
Another important category of yuan denominated bonds is yuan bonds issued by the PRC
entities in Hong Kong, China. The important issuers include the PRC’s Ministry of Finance
(MoF), Bank of China (BoC), Export and Import Bank of China (EIBoC), and Ping An China
Asset Management. In fact, the BoC and the EIBoC have been issuing yuan denominated
bonds in Hong Kong, China for several years. In addition, MoF issued 20 billion yuan in yuandenominated bonds in Hong Kong, China on 23 August 2011. This particular issuance was
regarded as a major boost to yuan internationalization and a “big gift” to Hong Kong, China
people by both Hong Kong, China and the PRC mass media.
The most popular category of yuan bonds are the so-called "dim sum" bonds, which are issued
in Hong Kong. China. The amount of each such bond issue is relatively small. Hopewell
Highway Infrastructure sold 1.38 billion yuan ($147 million) two-year yuan denominated bonds
in July 2010, which were the first yuan bonds sold offshore by a nonfinancial Hong Kong,
China-based company in Hong Kong, China. McDonald’s, Bank of East Asia, HSBC, Bank of
Tokyo Mitsubishi UFJ, Deutsche Bank, Tesco, and Caterpillar are among the other important
issuers. More than a total of 54 billion yuan of dim sum bonds had been issued by August
2011, up from 34 billion yuan for the whole of 2010 (Bloomberg 2010).
5.4
Yuan Swaps with Foreign Central Banks
Central bank liquidity swap arrangements allow the PBOC to provide liquidity support to its
counterparts. Foreign banks sell a specified amount of their currency to the PBOC for yuan, at
the market exchange rate. Yuan funds obtained by foreign central banks are deposited in
accounts held with the PBOC as PBOC liabilities. The countries that have currency swap
arrangements with the PRC include Argentina, Australia, Belarus, Brazil, Iceland, Indonesia,
Kazakhstan, Korea, Malaysia, New Zealand, Singapore, the United Arab Emirates, and
Uzbekistan. To facilitate yuan internationalization, the Hong Kong Monetary Authority (HKMA)
has entered into a three-year currency swap arrangement totaling 200 billion yuan with the
PBOC. Besides these swap agreements, more countries have expressed their interest in
holding yuan assets as investment or foreign exchange reserves. This channel of yuan
internationalization may be worth exploring further.
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6. PROBLEMS OF YUAN INTERNATIONALIZATION
However, all is not well with yuan internationalization. Since late 2010, yuan
internationalization has shown a clear pattern of asymmetry—the use of the yuan as an import
settlement currency rose quickly, but not for exports. Yuan denominated bonds met strong
demand, yet nonresidents had no incentive to issue them. And, while Hong Kong, China banks
are happy to extend yuan loans, they are not welcome by borrowers. Among all manifestations
of asymmetry, the most important asymmetry is in the use of the yuan for import settlement in
relation to export settlement. This asymmetry has caused much debate among the PRC
economists.
Before the debate on asymmetry had settled, another anomaly emerged: the yuan suddenly
devalued for 11 consecutive days in early December 2011, while the PRC was still running a
large current account surplus and a long-term capital account surplus. The asymmetry in the
use of the yuan as a settlement currency and the unexpected devaluation of the yuan have
forced economists to reconsider the reliability of the road map of yuan internationalization and
even about the desirability of internationalization.
6.1
Asymmetry of Yuan Internationalization and Resulting Welfare
Losses to the PRC
The asymmetry between yuan import settlement and yuan export settlement (Table 3) peaked
in the fourth quarter of 2010, when the amount of yuan used for import settlement was 12
times more than that used for export settlement. Certainly, the asymmetry has been
dramatically reduced since the second quarter of 2011. However, this weaker asymmetry was
not a natural development of yuan trade settlement as hoped by the designer of the road map
of yuan internationalization, which is an issue to be discussed in next subsection.
Table 3: Yuan Import Settlement to Yuan Export Settlement Ratio
Time (quarter)
Import-to-export Ratio
(yuan settlement)
6.67
7.97
7.97
11.00
8.11
2.90
1.67
2010Q1
2010Q2
2010Q3
2010Q4
2011Q1
2011Q2
2011Q3
Source: China International Economic Consultants Co. Ltd. (CIEC) databank (2012) and People's Bank of China,
Financial Reports, various issues.
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It can be argued that, given strong expectations of yuan appreciation, internationalization will
lead to serious asymmetry in yuan trade settlement. For example, with an undervalued
exchange rate and expectations for the yuan to appreciate, it is natural that foreign importers
of the PRC exports are reluctant to use the yuan to settle transactions, while foreign exporters
are happy to accept yuan. Yuan appreciation expectations no doubt have played an important
role in creating asymmetry. However, more recent development shows that the asymmetry is
much more than a result of yuan appreciation expectations.
Most researchers will assume that in the PRC’s case, if the yuan is used for settlement, it must
also be used for invoicing. But, as mentioned earlier, this is simply wrong. Investigations show
that while indeed many PRC importers use the yuan for settlement, most of them still use the
US dollars for invoicing. This finding partially resolved the puzzle that the PRC importers are
willing to use the yuan for settlement when the yuan is in the process of appreciation. INow, it
can be seen that, because imports are still invoiced in the US dollars, yuan settlement does
not means that the PRC importers need to forfeit potential gains from yuan appreciation.
However, even this is not the end of the story. The true motivation behind the PRC importers
to use the yuan for settlement is the existence of opportunities for exchange rate arbitrage,
which we will be dicussed further in section 6.2.
Since 2011 experience has shown, that if the incentive for the PRC importers to use the yuan
for settlement is exchange rate arbitrage instead of more sustainable fundamentals, the
willingness of the PRC importers to use the yuan for settlement by the PRC importers can
suddenly disppear. In fact, due to the reserval of the spread between onshore and offshore
exchange rates, both the increase in the use of the yuan as import settlement currency and
yuan assets held by Hong Kong, China residents have stalled since the third quarter of 2011.
Of course, if the reversal is reversed again, the fortune will change again. This re-reversal
happened in the 4th quarter of 2011. The important point is that without making the yuan an
invoicing currency, the progress in using the yuan as a settlement currency is superficial. If
there is no way to make the yuan an invoicing currency within reasonable costs, could it be an
indication that the conditions for using the yuan as a medium of exchange have not matured
yet?
One of the most obvious adverse results with asymmetry is that, with the same trade surplus,
the PRC ends up with more foreign exchange reserves, which is what the designers of yuan
internationalization originally wanted to avoid. It is easy to understand why this has happened:
while the PRC continues to receive dollars from its exports, it gets fewer chances than before
to spend these dollar proceeds for imports.
The fact that Hong Kong, China residents recycle yuan in the form of holding yuan assets
instead of using yuan to purchase the PRC’s exports means that they have lent to the PRC.
Hence, there is another problem: yuan internationalization leads to extra capital inflows, which
makes the PRC’s balance of payments even more imbalanced. In the first three quarters of
2011, the PRC’s capital account surplus was $226 billion, an increase of 110% over the same
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period of 2010. The PRC’s capital account surplus has surpassed its current account surplus
once again since 2005. As a country that has been running a current account surplus for two
decades and has accumulated $3.2 trillion, the PRC should not encourage net capital inflows.
Another adverse consequence of the asymmetry is the rising currency mismatch on the PRC’s
national balance sheet. As a result of the yuan import settlement and recycling, yuan, Hong
Kong, China residents have increased their yuan assets, probably at the expense of their
dollar assets. At the same time, the PRC has increased its yuan liabilities (recycled yuan) and
its foreign assets (mostly dollar assets). In other words, yuan internationalization under the
current road map has led to a change in the currency structure of the PRC’s assets and
liabilities in disfavor of the PRC. Since the 1998–1999 Asian financial crisis, East Asia has
accumulated huge amounts of dollar denominated assets—mainly US government securities.
Due to the deterioration of the US fiscal position and the Federal Reserve’s expansionary
monetary policy since the subprime crisis, the PRC should replace dollar denominated assets
with yuan denominated assets as well as replace yuan denominated liabilities with dollar
denominated liabilities. Unfortunately, yuan internationalization has achieved the opposite
result. 11
By definition, an increase in yuan settlement for imports without a corresponding increase in
yuan settlement for exports 12 means an increase in yuan liabilities, which in turn means that
there must be a corresponding increase in assets in the PRC’s international balance of
payments. If the PRC does not wish to see the increase taking the form of an increase in US
dollar denominated foreign exchange, what should the PRC do? Assume the PRC originally
exports $1 trillion in products and imports $800 billion in products, its total balance of payments
surplus is $200 billion. If the PRC pays for $100 billion worth of imports in yuan, it will end up
with $100 billion more in foreign exchange reserves. If the PRC extends yuan credits
equivalent to $100 billion to foreign receipts that in turn use the borrowed yuan instead of
dollars to buy the PRC products worth $100 billion, the PRC’s yuan assets (yuan credits to
foreign borrowers) would increase and equal to the increase in its yuan liabilities (yuan
deposits or other forms of yuan assets held by nonresidents). As a result, the increase in dollar
denominated foreign exchange reserves would remain the same—$200 billion. In this second
case, the yuan has been used as the medium of exchange by the PRC’s importers, the store
of value by Hong Kong, China residents, the store of value by the PRC’s creditors and, finally,
the medium of exchange by foreign importers and the PRC’s exporters. In other words, when
the provision of yuan to the global market is realized through a capital account deficit, the PRC
would be able not only to avoid further accumulating foreign exchange reserves and causing a
perverse change in the currency structure of the PRC’s assets and liabilities, but also give the
11
It can be argued that if nonresidents invest in yuan assets with the yuan made available by yuan trade settlement
scheme, an equivalent among of dollar investment in the PRC will be reduced. This substitution between yuan
investment and dollar investment is not very likely, because the investors are different with different motivation.
12
This is the most discussed feature of asymmetry in the PRC.
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yuan more room to play the role of an international currency. Of course, this is not to say that
yuan internationalization should begin with the PRC running a capital account deficit. The
reality is more complicated. But the argument that the yuan internationalization has to begin
with yuan import settlement is flawed.
6.2
Surge in Speculative Short-term Capital Flows
On the surface, the trade settlement scheme merely allows the PRC enterprises to use yuan to
settle their trade transactions. In reality it enables enterprises, especially large enterprises with
subsidiaries outside borders, to channel funds across the border between the PRC and Hong
Kong, China. The starting point of yuan internationalization is supposed to be the use of the
yuan for import settlement. But in practice, many PRC importers did not use the yuan to pay
for their imports—let alone to use the yuan for invoicing. Instead, they utilize the opportunity
provided by the trade settlement scheme, to conduct exchange rate arbitrage.
As a result of the launch of the trade settlement scheme, an offshore yuan market, known as
the CNH market, was created in Hong Kong, China, side by side with the onshore market, now
dubbed as the CNY market. The CNH market is a free market, while the CNY market is tightly
regulated by the PBOC. Hence, two yuan exchange rates coexist: an onshore CNY exchange
rate and an offshore CNH exchange rate. Due to yuan appreciation expectations and many
other factors, until September 2011 the CNH was more expensive in dollar terms than the
CNY. The existence of the CNH–CNY spread creates opportunities for the PRC enterprises to
benefit from exchange rate arbitrage. Before the introduction of the yuan settlement scheme,
importers had to buy dollars onshore—in the CNY market. Now they can sell yuan for dollars in
the CNH market, creating appreciation pressure on the CNY and depreciation pressure on the
CNH. The arbitrage should have eliminated the CNH–CNY spread fairly quickly. However, the
intervention by the PBOC in the CNY market and carry trade conducted by Hong Kong, China
residents in the CNH market created offsetting pressure on the CNY and the CNH. As a result,
the CNH–CNY spread was maintained and arbitragers and arbitrage activities by the PRC
importers continue. It is not unreasonable to conclude that the bulk of yuan used in the name
of import settlement actually is used to buy dollars in the CNH market and imports in fact are
still settled in dollars.
Table 3 shows that that yuan import settlement and yuan export settlement has become more
balanced since the second quarter of 2011. Would it not be proof for the argument that
following the increase in yuan availability across borders, the use of the yuan for export
settlement will increase accordingly? Unfortunately, the tendency for a more balanced yuan
settlement is deceptive. Since the middle of September 2011, financial conditions suddenly
changed in Hong Kong, China. Due to liquidity shortages caused by the European sovereign
debt crisis, banks from developed countries, especially European banks with exposure in Hong
Kong, China withdrew their funds. As a result, CNH fell against the dollar and the CNH–CNY
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spread turned negative. The PRC importers stopped buying dollars from the CNH market and
returned to the CNY market. The PRC exporters stopped selling dollars in the CNY market and
sold dollars in the CNH market instead. At the same time, because of a dramatic rise in
funding costs for carry trade and the reduced attraction of holding yuan assets, Hong Kong,
China residents started to unwind the carry trade and some dumped their holdings of yuan
assets. Statistically, the yuan import–export settlement became more balanced. But this
change is not a reflection of the success of yuan internationalization. It reflects the fluctuation
of the movements of short-term capital flows across borders. Empirical studies (Zhang and Xu
2011) show that the yuan import–export settlement ratio (receive-to-pay ratio) is highly correlated
with the CNH–CNY spread (Figure 3).
Figure 3: Correlation Between CNH–CHY Spread and Yuan Import–Export
Settlement Ratio
Source: Zhang and Xu (2011).
Before the launch of the yuan settlement scheme, capital inflows were under tight control, and
nonresidents couldn’t obtain yuan assets freely. Yuan assets are now being made available in
Hong Kong, China so nonresidents can obtain yuan assets outside their border. It can be seen
that ultimately, questions such as how to promote the use of the yuan for trade settlement and
to make the use of the yuan more balanced so that the PRC can avoid further accumulating
foreign exchange reserves are the wrong questions. The real question is: after a very big step
towards capital account liberalization, how will speculative capital move across borders?
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Important questions include: what will be the consequences of these movements on the PRC’s
financial and macroeconomic stability?
7. YUAN INTERNATIONALIZATION AND CAPITAL ACCOUNT
LIBERALIZATION
According to the trade settlement scheme, currency conversion between the yuan and other
currencies is allowed only under the following circumstances:
•
cross-border trade settlement in yuan up to the amount of the relevant transactions;
•
yuan trade finance loans where the customer does not have sufficient yuan for
repayment;
•
expenses relating to yuan bond issuance to be settled in Hong Kong, China; and
•
transactions allowed by the PRC’s authorities to be ultimately squared by the yuan
clearing bank—Bank of China, Hong Kong (BOCHK) in the PRC’s Foreign Exchange
Trading Centre in Shanghai.
To maintain control over the net cross-border flows of yuan between the PRC and Hong Kong,
China, all cross-border yuan flows must be settled via the BOCHK (Figure 4).
Figure 4: Yuan Settlement System
Notes: CNAPS = China National Automatic Payment System; PRC = People’s Republic of China; RTGS = real time
gross settlement systems.
Source: Shum, A. 2012. Renminbi Offshore Market and Future Globalization of Chinese Currency. Presentation at
Rotman Master of Finance Speaker Series, University of Toronto, Canada. 15 February.
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There are quotas for monthly settlements. Initially, the quarterly amount of net buying from or
selling to the BoC was limited to 4 billion yuan. Later it was raised to 8 billion yuan. It is worth
emphasizing that the quotas are net rather than gross amount of settlement. It is estimated
that in 2011 around 70% of the PRC’s yuan cross-border trade settlement was done through
the BOCHK’s clearing system (Zhang 2012).
One might ask how the yuan can be internationalized without first liberalizing the capital
account. However, this is the wrong question. The truth is that yuan internationalization is an
effort for capital account liberalization in disguise. Each step in yuan internationalization is a
step in capital account liberalization. It can be said that if progress has been made in yuan
internationalization, it is a result of capital account liberalization. In fact, since early 2002, the
PBOC has started to call for a further liberalization of capital account.
One can make a thought experiment. Assuming that no effort is made to promote yuan
internationalization, but the capital account is partially liberalized so that foreign capital can
flow into the PRC’s financial markets to acquire yuan assets, compared to the circumstances
where the yuan is used for trade settlement, will there be any differences in the role of the
yuan between the two? If the CNH is more expensive than the CNY and the interest rate is
higher in the PRC than in Hong Kong, China, dollars will flow from Hong Kong, China into the
PRC to buy yuan assets, the PRC importers will buy US dollars in the CNH market instead of
in the CNY market, and the PRC exporters will sell their dollar proceeds onshore. It can be
seen that under the scenario of partial capital account liberalization, results will be the same as
in the event of yuan internationalization. The differences exist only in channels and
mechanisms leading to the same results. For example, under the scenario of partial capital
liberalization, Hong Kong, China residents buy yuan assets directly in the PRC’s financial
markets instead of in Hong Kong, China. In event of yuan settlement, yuan assets are acquired
in Hong Kong, China.
After over two years’ effort since 2009, despite the significant increase in yuan trade
settlement, the PRC’s trade is still largely invoiced in the dollar and yuan trade settlement is
highly asymmetrical. Yuan internationalization has not achieved any of its original objectives,
such as sheltering its export industries from exchange rate risks and reducing the holding of
dollar denominated assets to avoid capital losses on foreign exchange reserves.
In contrast, the PRC’s capital account liberalization has made some progress, which is
evidenced by the surge of cross-border capital movements in response to changes in the
global financial conditions. Since early 2010, the PRC government actually has been pushing
two processes simultaneously—capital account liberalization and yuan internationalization—
one by stealth and the other with much fanfare. Because each step toward yuan
internationalization is prerequisite upon certain steps in capital account liberalization, an
important question is whether the sequencing of capital account liberalization implied by the
road map of yuan internationalization is consistent with the sequencing of capital account
liberalization, which is well established in the literature and in practice. If the two sets of
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sequencing are the same, it will not make much difference which process should take
precedence. If the two sets of sequencing are not the same, it becomes impossible for the
government to have two correct sets of sequencing at the same time.
Despite the fact that each step toward yuan internationalization is a prerequisite upon certain
steps in capital account liberalization, capital account liberalization and especially the
sequencing have never been discussed explicitly. Yuan internationalization is widely talked
about, while capital account liberalization hides in the shadows. The steps with consequences
on capital account liberalization are taken in the need for yuan internationalization. This
situation will easily lead to missteps in capital account liberalization. For example, the starting
point of yuan internationalization is the use of yuan for import settlement. This step is
prerequisite upon a certain degree of liberalization of cross-border capital movements.
However, the road map for yuan internationalization has said nothing about the need for
interest rate liberalization and a flexible exchange rate regime. As a result, the cross-border
capital flows as a result of yuan import settlement certainly will create distortions in resource
allocation and interruptions in the PRC’s financial stability. In my view, it is much better to draw
a road map for capital account liberalization and explicitly discuss the sequencing of the
liberalization. The road map of yuan internationalization should be decided on the basis of the
road map of capital account liberalization.
Capital account liberalization in the PRC is a drawn out process. After having entirely
liberalized its current account, the PRC has also liberalized the best part of its capital account.
While there is no denying that, on top of a turbulent global financial environment, with a still
fragile financial system, capital account liberalization should be pursued cautiously. However,
this does not necessarily mean that the PRC should not discuss options for the completion of
the few final steps in the long march toward capital account liberalization. If the conclusion is
that no further action should be taken to liberalize the capital account, then action aimed at
yuan internationalization should not be allowed to lead to a further liberalization of the capital
account.
It seems that the PRC should first speed up interest rate liberalization so as to eliminate the
enormous chances for arbitrage and rent seeking. At the same time, the yuan exchange rate
should be liberalized in the sense that it is decided by market demand and supply. The PBOC
could stop intervention in the foreign exchange market. It is a much simpler way to stop the
accumulation of foreign exchange reserves. If the PRC still does not wish to do so, then there
should be no more talk about capital account liberalization. With inflexible interest and
exchange rates, capital account liberalization will render monetary policy ineffective and create
large welfare losses for the PRC.
The argument that exchange rate reform needs a longer time than yuan internationalization is
difficult to understand. In my view, due to the eurozone sovereign debt crisis, and the sudden
surfacing of bearish sentiment about the PRC, yuan appreciation expectations have reduced
significantly. In the past few months since the last quarter of 2011, yuan devaluation
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expectations appeared in CNH forward and non-deliverable forward (NDF) markets. In
December 2011, the yuan devalued for 11 consecutive days. These changes in sentiment and
the new trend of capital outflows from emerging economies have provided the PRC with a rare
opportunity to allow the yuan to float. Certainly, because capital account controls in the PRC
have not been fully dismantled, the government can always use the prudential rule and other
laws and regulations to manage cross-border capital flows to prevent overshooting of the
exchange rate. Only when the exchange rate can adjust constantly around its equilibrium level
and domestic interest rates are flexible enough in response to the fluctuations of cross-border
capital flows, can the opportunity for exchange rate arbitrage and interest rate arbitrage be
minimized. Then the internationalization of the yuan can be preceded in line with market
conditions and with minimum welfare losses.
8. CONCLUSION
The internationalization of the yuan is a major challenge facing the PRC government.
However, the PRC has yet to give a firm answer on what should be the final goal of
internationalization. Fortunately, yuan internationalization does not currently conflict with other
possible options, such as the creation of a supra-sovereign currency or a regional currency.
While the PRC can benefit from the internationalization of the yuan, its possible negative
effects on the PRC’s financial stability may also be serious.
The twists and turns of yuan internationalization in 2011 raises a very important question: does
the PRC want to take the risk of fully liberalizing its capital account without first putting its own
house in order and giving the market force full play in determining the interest rates and
exchange rates? The question facing the PRC is not about the desirability of yuan
internationalization. It is about the prioritization of the PRC’s financial reforms and regime
changes. The question becomes even more acute when taking into consideration the fact that
the global financial market is still in turmoil and the PRC’s financial markets are in a messy
state. It is risky to pin the hope of the emergence of a healthier and more robust financial
system on the creative destruction of external shocks, while the existing system is still too
weak to withstand such shocks.
The internationalization of the yuan requires convertibility and liberalization of the capital
account. Due to the fragility of the financial system and its lack of attractive financial
instruments, the PRC’s liberalization of the capital account and hence the internationalization
of the yuan must proceed in a gradual fashion.
Yuan internationalization should be a natural course of economic development and capital
account liberalization. To push yuan internationalization in an artificial way is counterproductive. Policies aimed at promoting yuan internationalization should not be based on yuan
appreciation. Otherwise, internationalization will not be sustainable.
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The PRC’s growing economy and trade volume are favorable conditions for
internationalization. However, other conditions, such as the existence of deep and liquid
financial markets, have not been met. To create conditions for the internationalization of the
yuan, the PRC government should encourage financial markets to play an increasingly
important role.
Sequencing is important. Without the initial realization of establishing market-determined
interest rates and exchange rates, yuan internationalization could easily go astray. The
process of yuan internationalization essentially is a process of capital account liberalization.
Due to the unprecedented and complex global financial crisis and the PRC’s huge imbalances,
capital account liberalization should be pursued in a cautious way. The PRC should first put its
own house in order. Before the internationalization of the yuan can make progress, the PRC
must speed up the reform of its financial markets. Interest rates should be liberalized. At the
same time, the yuan exchange rate should be allowed to float freely. Only when the PRC’s
financial reform makes an important breakthrough, can the internationalization of the yuan be
able to make meaningful progress.
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